Greg Mankiw's Blog

Random Observations for Students of Economics

Saturday, February 28, 2009

What is a deficit hawk to do?

I love the title of the Obama administration's budget document, "A New Era of Responsibility." But do the numbers back up the marketing? In particular, should deficit hawks rejoice in this new found responsibility in the nation's capital? Are we about to put federal government on a sounder fiscal footing, leaving a smaller debt to future generations?

Few economists would blame either the Bush or Obama administrations for running some degree of budget deficit during economic downturns. While we might argue about the size of the appropriate deficit, lower tax revenue and greater outlays on, say, unemployment insurance are a natural and appropriate response to recessions and their immediate aftermath. What is more telling is what happens to the budget picture during periods of economic normalcy.

With that perspective in mind, let's compare the previous and current administration.

During the period 2005 to 2007, the U.S. unemployment rate hovered in the ballpark of 5 percent. What was the budget balance? According to OMB historical documents, the budget deficit averaged just under 2 percent of GDP during those three years.

Now compare these results to the new Obama budget. For the moment, let's put aside concerns about the economic forecast on which the budget is based and take their figures at face value. According to the Obama administration numbers, the economy will reach normalcy of 5 percent unemployment in year 2014, and they project unemployment remaining at that level thereafter. (I infer they take 5 percent to be an estimate of the natural rate of unemployment, which seems reasonable.) What happens to the budget balance when we get to that long-run equilibrium? According to their numbers, under their proposed policies, the budget deficit will average a bit over 3 percent of GDP during that time.

The bottom line: If you are a deficit hawk who lamented the Bush budget deficits, the new administration's budget should not make you feel much better. President Obama will give us different fiscal priorities than President Bush did, but the borrowing and debt imposed on future generations will not be very different, at least if the numbers presented in the Obama administration's own budget document can be trusted.

Ten Facts about Kevin Murphy

Friday, February 27, 2009

A Speech from the CEA Chair

Rosy Scenario, or the Audacity of Hope?

Here (in red) are the growth forecasts used to put out the new Obama administration budget, followed by the consensus forecast of a panel of "Blue Chip" private forecasters (in blue, naturally). (Source. Go to Table 3.)

The Obama administration's outlook has private economists wondering: Has Rosy Scenario made a comeback?...

Nariman Behravesh, chief economist at IHS Global Insight, a major private forecasting firm, called the administration's forecasts "way too optimistic" and said it could represent a return to the overly optimistic forecasts of previous administrations confronted by surging budget deficits.

"They used to joke during the Reagan years that the highest ranking woman in the administration was Rosy Scenario," he said. "We may be seeing a return of Rosy Scenario."

Speaking to reporters Thursday, White House economist Christina Romer called the projections an "honest forecast" by the administration's professional forecasters. "I'd reject the premise that we're noticeably rosier," she said. "We certainly are somewhat more optimistic, but certainly nothing out of the ballpark."

Moving the Goal Posts

In constructing their budget baseline – the metric against which the costs of policy changes are measured – the Administration departed from the practice of assuming a “current-law” baseline, and instead decided to use a “current-policy” baseline. A current-law baseline assumes that changes in the budget will occur as they are scheduled to under the law (i.e. provisions scheduled to expire will be allowed to do so). Instead, Obama’s baseline assumes: 1) the practice of patching the AMT on an annual basis will continue; 2) all of the 2001/2003 tax cuts will be made permanent; 3) the wars in Iraq and Afghanistan will continue to cost as much as in FY2008 (inflation adjusted); 4)Congress will continue to enact “Medicare Pay Patches;” and 5) funding will be allotted for anticipated disaster relief....

Taken together, the measures in the Obama baseline will increase this new current law baseline deficit by $482 billion (excluding interest) in FY2013 and more than $5 trillion over ten years. (Interest payments account for another $1.5 trillion over ten years, but some of this is due to already-enacted legislation such as the economic stimulus). President Obama will use this baseline, rather than a current-law baseline, to assess whether new policies meet the goal of budget neutrality, and from this metric his proposals reduce the deficit by roughly $2 trillion over ten years....

The budget includes many policies that have been omitted in recent budgets, such as the cost of patching the Alternative Minimum Tax and funds for operations in Iraq and Afghanistan. The Administration should be commended for the increase in transparency in the budget resulting from including the policies they support. This is a vast improvement on the past practice of omitting policies that would clearly be part of the budget.

However, by putting these policies not just in the budget, but in the baseline, the Administration gives itself a free pass on paying for patching the AMT, making the 2001 and 2003 tax cuts permanent, and the costs of not abiding by the slated Medicare physical payment cuts. Choosing not to offset the costs of these policies is a clear violation of the PAYGO principle, where the cost of new policies should be offset through additional savings.

Assuming that war spending will continue at FY2008 levels (adjusted for inflation) – an amount even beyond what President Bush’s policy would have required – strikes us as a gimmick to build up the spending amount in order to reduce it and claim “savings”.

That is, even before the Obama tax hikes, the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile. These data do not tell you the optimal degree of tax progressivity, but they do describe the starting point from which policy is working.---

Which budget deficit?

Case StudyAccounting for TARPIn 2008, many U.S. banks found themselves in substantial trouble, and the federal government put substantial taxpayer funds into rescuing the financial system. A case study in Chapter 11 discusses the reasons for this financial crisis, the ramifications, and the policy responses. But here we note one particular small side effect: It made measuring the federal government’s budget deficit more difficult.

As part of the financial rescue package, called the Troubled Assets Relief Program (TARP), the U.S. Treasury bought preferred stock in many banks. In essence, the plan worked as follows. The Treasury borrowed money, gave the money to the banks, and in exchange became a part owner of those banks. In the future, the banks were expected to pay the Treasury a preferred dividend (similar to interest) and would eventually repay the initial investment as well. When that repayment occurred, the Treasury would relinquish its ownership share in the banks.

The question then arose: How should the government’s accounting statements reflect these transactions?

The U.S. Treasury adopted the conventional view that these TARP expenditures should be counted like any other spending. When the banks repaid the Treasury, these funds would be counted as revenue. Accounted for in this way, TARP caused a surge in the budget deficit when the funds were distributed to the banks, but it would lead to a smaller deficit, and perhaps a surplus, in the future when repayments were received from the banks.

The Congressional Budget Office, however, took a different view. Because most of the TARP expenditures were expected to be repaid, the CBO thought it was wrong to record this spending like any other. Instead, CBO believed “the equity investments for TARP should be recorded on a net present value basis adjusted for market risk, rather than on a cash basis as recorded thus far by the Treasury.” That is, for the purposes of this program, CBO adopted a form of capital budgeting. But it took into account that these investments might not pay off. In their estimation, every dollar spent on the TARP program cost the taxpayer only about 25 cents. If the actual cost turned out to be larger than the estimated 25 cents, the CBO would record those additional costs later, and if the actual cost turned out to be less than projected, the CBO would later book a gain for the government.

The bottom line: Because of these differences in accounting, while the TARP funds were being distributed, the budget deficit as estimated by CBO was much smaller than the budget deficit as recorded by the U.S. Treasury.

Estimates of the value of the financial assets acquired by the Federal Government to date suggest that the Government will get back approximately two-thirds of the money spent purchasing such assets—so the net cost to the Government is roughly 33 cents on the dollar. These transactions are typically reflected in the budget at this net cost, since that budgetary approach best reflects their impact on the Government’s underlying fiscal position. The figure recorded in this Budget as a placeholder similarly reflects this net cost concept. The $250 billion reserve would support $750 billion in asset purchases.

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Addendum: If you teach macroeconomics and would like to consider the 7th edition for your course, please contact Scott Guile at sguile@whfreeman.com.

Moral Hazard

Victor Zarnowitz

POTUS Approval after One Month

President Obama's job approval is now 63 percent, which is almost exactly the average over the past 40 years for Presidents at this point in their first terms (62 percent). His disapproval rating is a bit higher than average (24 versus 16 percent).

The Formula That Killed Wall Street

Glaeser on the Mortgage Interest Deduction

Leonhardt vs Obama

In order to save our children from a future of debt, we will also end the tax breaks for the wealthiest 2% of Americans. But let me perfectly clear, because I know you’ll hear the same old claims that rolling back these tax breaks means a massive tax increase on the American people: if your family earns less than $250,000 a year, you will not see your taxes increased a single dime. I repeat: not one single dime. In fact, the recovery plan provides a tax cut – that’s right, a tax cut – for 95% of working families.

To the extent that Mr. Obama has talked about raising taxes, he has focused on households that make at least $250,000 a year. And their taxes will certainly need to go up. In the last three decades, as the pretax income of the top 1 percent of earners has soared, their total federal tax rate has fallen to 31 percent, from 37 percent, according to the Congressional Budget Office.

But the problem can’t be solved just by taxing the rich. That top 1 percent pays only about one-quarter of federal taxes. Once the recession ends, taxes on the not-so-rich will need to rise, too.

Tuesday, February 24, 2009

Mixed Messages

US Secretary of State Hillary Clinton has pleaded with China to continue buying US Treasury bonds amid mounting fears that Washington may struggle to finance bank bail-outs and ballooning deficits over the next two years. "It's a safe investment. The United States has a well-deserved financial reputation," she told Chinese television stations at the end of her diplomatic tour of Asia.

President Barack Obama believes China is “manipulating” its currency, his choice to head the U.S. Treasury said on Thursday....Washington will “aggressively” use all its diplomatic tools to press Beijing to move faster on currency reform, New York Federal Reserve Bank President Timothy Geithner said ...U.S. Treasury bond prices fell on worries China could respond to Mr. Geithner’s frank comments by dumping U.S. Treasury bonds.

The inconsistency in the policy here becomes fully apparent only when one understands how China "manipulates" its currency: It keeps the value of the yuan lower than it otherwise might be by supplying yuan and demanding dollars in foreign-exchange markets. Those dollars are then invested in U.S. Treasuries.

In other words, Secretary Clinton is now asking the Chinese to do precisely what Secretary Geithner asked them not to do.

The Paradox of Thrift

Monday, February 23, 2009

The Cool Rides of the Econ Geeks

The vehicles owned by the Obama administration's auto team could reflect one reason why Detroit's Big Three automakers are in trouble: The list includes few new American cars. Among the eight members named Friday to the Presidential Task Force on the Auto Industry and the 10 senior policy aides who will assist them in their work, two own American models....

Is macro policy overreacting?

The U.S. political-economic system gives evidence of a phenomenon known as “instrument instability.” Policy makers at the Federal Reserve and the White House are attempting to use highly imperfect monetary and fiscal policies to stabilize the national economy. The result, however, has been ever-more desperate swings in economic policies in the attempt to prevent recessions that cannot be fully eliminated.

President Barack Obama’s economic team is now calling for an unprecedented stimulus of large budget deficits and zero interest rates to counteract the recession. These policies may work in the short term but they threaten to produce still greater crises within a few years. Our recovery will be faster if short-term policies are put within a medium-term framework in which the budget credibly comes back to balance and interest rates come back to moderate sustainable levels....

We need to avoid reckless short-term swings in policy. Massive deficits and zero interest rates might temporarily perk up spending but at the risk of a collapsing currency, loss of confidence in the government and growing anxieties about the government’s ability to pay its debts. That outcome could frustrate rather than speed the recovery of private consumption and investment. Deficit spending in a recession makes sense, but the deficits should remain limited (less than 5 percent of GNP) and our interest rates should be kept far enough above zero to avoid wild future swings.

The Fiscal Gap

In 2009, the federal deficit will be larger as a share of the economy than at any time since World War II. The current deficit is due in part to economic weakness and the stimulus, and in part to policy choices made in the past. What is more troubling is that, under what we view as optimistic assumptions, the deficit is projected to average at least $1 trillion per year for the 10 years after 2009, even if the economy returns to full employment and the stimulus package is allowed to expire in two years. The longer-run picture is even bleaker. We estimate a fiscal gap – the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt/GDP ratio at its current level – about 7-9 percent of GDP, or between $1 trillion and $1.3 trillion per year in current dollars.

Thursday, February 19, 2009

Banks vs Holding Companies

"Create or Save"

Now that the stimulus bill has been passed and signed, we might ask: How will we know if it has worked? This passage from the President's Feb 9 press conference (with my emphasis added) gives a clue about his own thinking:

Question: The American people have seen hundreds of billions of dollars spent already, and still the economy continues to free-fall. Beyond avoiding the national catastrophe that you've warned about, once all the legs of your stool are in place, how can the American people gauge whether or not your programs are working? Can they — should they be looking at the metric of the stock market, home foreclosures, unemployment? What metric should they use? When? And how will they know if it's working, or whether or not we need to go to a plan B?

Answer: I think my initial measure of success is creating or saving 4 million jobs. That's bottom line No. 1, because if people are working, then they've got enough confidence to make purchases, to make investments. Businesses start seeing that consumers are out there with a little more confidence, and they start making investments, which means they start hiring workers. So step No. 1, job creation.

The expression "create or save," which has been used regularly by the President and his economic team, is an act of political genius. You can measure how many jobs are created between two points in time. But there is no way to measure how many jobs are saved. Even if things get much, much worse, the President can say that there would have been 4 million fewer jobs without the stimulus.

An actual answer to the question "What metric?" could have taken the form: "If the unemployment rate on [insert date] is below [insert threshold], I will judge the plan to be a success." Given the uncertainties inherent in the economy, however, no sensible politician would hold himself to such a measurable standard. But the President also wanted to avoid sounding like he was avoiding accountability. So he gave us a non-measurable metric. A clear and specific benchmark, without any way of ever knowing whether it has been reached.

A completely honest (but perhaps politically ill-advised) response to the question would have been, "Geez. I am only President of the United States. I cannot be held responsible for everything that what happens with the economy!" If he had said that, I would have agreed with him.

----Update: A regular reader of this blog (who deserves anonymity) misinterpreted my meaning, so let me clarify: The 4 million job number is a counterfactual policy simulation of what the stimulus will do based on a particular model of the economy. As such, I have no objection to someone citing it in a policy discussion. In fact, macroeconomists use models to generate figures like this all the time. I have even done it myself.

But as an answer to the question "how can the American people gauge whether or not your programs are working?... What metric should they use?", citing the 4 million job figure is a non sequitur, or more likely a diversion. A metric has to be measurable, and the actual number of jobs "created or saved" by the policy will never be measurable from any data source.

Wednesday, February 18, 2009

Allocating Harvard's Resources

The economics department is perennially plagued with abysmal satisfaction ratings and high student-to-faculty ratios.

It is true that student satisfaction is lower in economics than in most other departments at the university and that student-faculty ratios are higher. I have been told, however, that if you do a regression of a department's student satisfaction on its student-faculty ratio, the economics department is right on the regression line. This fact suggests that our student satisfaction is low precisely because the student-faculty ratio is high.

The Crimson editorial implores the econ department to take action to prevent the elimination of the junior seminar program. But that will prove hard to do with existing resources. If the student-faculty ratio is the ultimate problem leading to low satisfaction with the econ major, and I believe that it is, there are two ways to improve the situation: Increase the number of economics faculty or decrease the number of economics students.

I am confident we in the economics department would be happy to hire more faculty if only the university would allocate us more faculty slots. In a world of finite resources, the question becomes, where would those faculty slots come from? I would be eager to hear from the students which departments they think should shrink.

Or maybe there are other options. If there are administrative departments that could be reduced or eliminated, that could make room for more faculty. Or, following Brandeis, we could sell off some of the collection in the university art museum! Universities like people, face tradeoffs. If the university is to provide more small classes in econ, it will need to provide less of something else. Right now, I do not see the university administration making substantial efforts to find more resources for the economics department. Sadly, we are not a major priority.

The alternative way to get the student-faculty ratio down in the economics department is to reduce the number of students. Right now, despite the low satisfaction reported on student surveys, economics is the most popular major. The economics department could reduce the number of students by making econ a selective major (e.g., you would need a certain grade in ec 10) or by raising requirements (e.g., every major would have to take multivariate calculus and linear algebra).

Many faculty in the economics department would object to trying to reduce the number of students because we think it is great that so many students choose to major in economics. But if the students make this choice, and the university fails to allocate resources to increase faculty and bring the student-faculty ratio closer to the university average, then it seems almost inevitable that students will leave the major with a below average level of satisfaction.

There is one final possibility: Some angel with deep pockets could give the university a wad of cash with the stipulation that it be spent on the economics department. If any would-be angels are out there reading this blog post, we in the economics department would be happy to hear from you.

Tuesday, February 17, 2009

To Debate or Not

Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing Obama's stimulus plan. As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus -- thinking that would be a timely and lively session. But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that "all I know on this issue I got from Greg Mankiw's blog -- I really am not equipped to debate this with anyone."

Various bloggers have quoted this story as evidence for the sad state of the economics profession. My interpretation is more benign: The chairman of the department asks a professor to do something, the professor is busy and doesn't really want to do it, so he blows off the chairman with a tongue-in-cheek quip.

On a related note: I know a lot of academics who don't like debate formats. They find it too confrontational and incompatible with reasoned discussion. A prominent economics professor I know, who once faced off against Larry Summers in a debate, told me he would never put himself in that position again. But that decision has not stopped him from being a productive contributor to discussions of public policy.

An Increase in Marginal Tax Rates

As I have been saying for the last month or so, when I saw the details of the tax rebate (and I'm sure other marginalists have been saying so too), under the "stimulus" bill that President Obama will sign today, marginal tax rates for some of the most-productive people in the world will rise. That's what happens when the government gives a rebate or a tax credit and then phases it out above some income level. Marginal tax rates rise for the range of income in which the phaseout occurs....For single taxpayers (the WSJ says "workers" but I'm not sure you need to work to qualify) , the rebate phases out after $75,000 of income by $20 for every additional $1,000 of income. The tax credit for singles is $400. So for singles in the income range from $75K to $95K, marginal tax rates in income will be two percentage points higher. For married taxpayers, the tax credit is $800; it phases out after $150,000 of income by the same $20 per $1,000 of income. So for married taxpayers with income between $150,000 and $190,000, marginal tax rates will be two percentage points higher.

Bebchuk on Pay Caps

Monday, February 16, 2009

China favors free trade, even if U.S. doesn't

Measures in a $789 billion U.S. stimulus package that favor American goods are a "poison" that will hurt efforts solve the financial crisis, an editorial by China's official news agency said. Provisions in the U.S. stimulus bill approved Friday favoring American steel, iron and manufactured goods for government projects are protectionist measures that could trigger trade disputes, said the editorial....

U.S. labor groups that pushed hard for inclusion of the measures have argued that their main purpose is to ensure that U.S. Treasury dollars are used to the fullest extent to support domestic job creation.

China has promised to avoid "Buy China" protectionist measures in its own multibillion-dollar stimulus effort, and appealed to other governments to support free trade....

President Barack Obama is expected to sign the economic stimulus package on Tuesday in Denver, Colorado.

Nationalization, or Pre-privatization?

I don't pretend to be enough of an expert, or to be close enough to the facts, or to have a large enough staff, to know what should be done with the banking system, which is at the center of our current economic turmoil. But I am confident that fixing it should be the main focus of policy efforts.

In this regard, I found this tidbit thought-provoking:

"The word 'nationalization' scares the hell out of people," Rep. Maxine Waters, D-Calif., said on "This Week." To combat that, some clever advocates of nationalization have come up with alternative names, including "government receivership" and "pre-privatization." (Source.)

The search for alternative names can be amusing at first, but I think there is more here than mere semantics.

Why are people scared about the idea of nationalization? One reason is that it is a sign of the depth of our problems. A second, more substantive reason is that it seems to point in a bad direction. I certainly do not want the government deciding who deserves credit and who does not, what kind of investments are worthy of financing and what kind are not. That is a big step toward crony capitalism, where the politically connected get the goodies, and economic stagnation awaits the rest of us.

If the government is to intervene in a big way to fix the banking system, "nationalization" is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure.

Bankruptcy could become, in effect, a massive bank recapitalization. Essentially, the equity holders are told, "Go away, you have been zeroed out." The debt holders are told, "Congratulations, you are the new equity holders." Suddenly, these financial organizations have a lot more equity capital and not a shred of debt! And all done without a penny of taxpayer money!

I am sure there are a host of legal issues here. The government cannot blithely walk into banks and tell them they are insolvent when the banks are saying (pretending? hoping? praying?) otherwise. But as bank regulators, the feds have more leeway with banks than they would with other types of business enterprise. How much leeway is an issue beyond my ken.

But there is one thing I am sure of: If this is the route we go down, the government had better get in and out as quickly as possible. If it is done right, nationalization will be the wrong word to describe the process.

Sunday, February 15, 2009

Talking Down the Economy

Bradley Schiller, author of a popular (though not the most popular) introductory economics textbook, says:

President Barack Obama has turned fearmongering into an art form. He has repeatedly raised the specter of another Great Depression....Mr. Obama's analogies to the Great Depression are not only historically inaccurate, they're also dangerous. Repeated warnings from the White House about a coming economic apocalypse aren't likely to raise consumer and investor expectations for the future. In fact, they have contributed to the continuing decline in consumer confidence that is restraining a spending pickup.

I am not convinced. In light of the diverse sources of information that the typical person receives, and the natural skepticism about what any politician says, I doubt that any president's rhetoric has a substantial influence on confidence.

A Victory for Populism

The giant stimulus package that cleared Congress Friday includes a last-minute addition that restricts bonuses for top earners at firms receiving federal cash -- including those that already received it -- more severely than the Obama administration's previous pay limits....As word spread Friday about the new and retroactive limit -- inserted by Democratic Sen. Christopher Dodd of Connecticut -- so did consternation on Wall Street and in the Obama administration, which opposed it. The administration is concerned the rules will prompt a wave of banks to return the government's money and forgo future assistance, undermining the aid program's effectiveness. Both Treasury Secretary Timothy Geithner and Lawrence Summers, who heads the National Economic Council, had called Sen. Dodd and asked him to reconsider.

This story is one sign about what concerns me about the direction of economic policy. President Obama has appointed some outstanding economic advisers. But policy will be determined largely by Congressional leaders whose instincts are more populist and less informed by solid economics.

Saturday, February 14, 2009

News Flash: Economists Agree

The recent debate over the stimulus bill has lead some observers to think that economists are hopelessly divided on issues of public policy. That is true regarding business cycle theory and, specifically, the virtues or defects of Keynesian economics. But it is not true more broadly.

My favorite textbook covers business cycle theory toward the end of the book (the last four chapters) precisely because that theory is controversial. I believe it is better to introduce students to economics with topics about which there is more of a professional consensus. In chapter two of the book, I include a table of propositions to which most economists subscribe, based on various polls of the profession. Here is the list, together with the percentage of economists who agree:

A ceiling on rents reduces the quantity and quality of housing available. (93%)

Tariffs and import quotas usually reduce general economic welfare. (93%)

Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative impact on a less than fully employed economy. (90%)

The United States should not restrict employers from outsourcing work to foreign countries. (90%)

The United States should eliminate agricultural subsidies. (85%)

Local and state governments should eliminate subsidies to professional sports franchises. (85%)

If the federal budget is to be balanced, it should be done over the business cycle rather than yearly. (85%)

The gap between Social Security funds and expenditures will become unsustainably large within the next fifty years if current policies remain unchanged. (85%)

Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value. (84%)

A large federal budget deficit has an adverse effect on the economy. (83%)

A minimum wage increases unemployment among young and unskilled workers. (79%)

The government should restructure the welfare system along the lines of a “negative income tax.” (79%)

Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%)

If we could get the American public to endorse all these propositions, I am sure their leaders would quickly follow, and public policy would be much improved. That is why economics education is so important.

Note that the proposition about fiscal policy (#4) does not distinguish between taxes and spending as the best tool for purposes of macro stabilization. Maybe that question should be added in a future poll. I doubt, however, that the answer would make it onto this list of widely agreed upon propositions.

Friday, February 13, 2009

Uncertainty and the MPC

I try not to spend too much time on this blog correcting journalists' spurious economic arguments. After all, the target is too easy, and time is too scarce. But I will make an exception for this Newsweek article by Daniel Gross, in part because he invokes my name so prominently and in part because his error is so edifying.

Essentially, what Gross says is that (1) people now face a lot of uncertainty, (2) therefore they are inclined to save rather than spend, and (3) therefore any tax cuts they might receive would have only a small effect on their spending.

On its face, that argument sounds reasonable. But there is a subtle logical leap that, I believe, does not bear up under closer scrutiny. The step from (1) to (2) makes perfect sense in the context of models of precautionary saving. (For the econ wonks out there, I am envisioning an intertemporal consumption model with either a positive third derivative of utility, so certainty equivalence fails, or the possibility of borrowing constraints). Essentially, what the precautionary-saving literature says is that more uncertainty reduces the average propensity to consume (APC), the ratio of consumption to income.

But statement (3) does not concern the average propensity to consume. It is about the marginal propensity to consume (MPC), which is the extra consumption generated by a dollar of extra income. Gross implicitly assumes that when uncertainty reduces the APC, it also reduces the MPC. The precautionary-saving literature, however, suggests otherwise.

Suppose we were to graph a household's consumer spending as a function of cash-on-hand, which equals current income plus liquid assets, holding constant expected future income. In a permanent-income world without precautionary saving effects, that consumption function would have a constant slope of r, the rate at which the consumer annuitizes wealth. That slope is the marginal propensity to consume.

Now introduce uncertainty and precautionary saving effects. That uncertainty would depress consumption at all levels of cash-on-hand, but it would depress consumption more at low levels of cash. Those with high cash levels can more easily bear the effects of the uncertainty and would change their consumption less. But if consumption is depressed more at lower levels of cash than at higher levels, then it follows, as a sheer mathematical matter, that the marginal propensity to consume from an extra dollar of cash has gone up. In other words, uncertainty lowers the APC but raises the MPC. People save more in response to uncertainty, but their spending becomes more sensitive to current cash flow.

Gross makes another, unrelated mistake. He suggests that, as a Harvard professor, I am an example of a person with a particularly stable income. (That is why, he intimates, I fail to appreciate the consumption decisions facing real people who face substantial uncertainty.) It is true that my university salary is reasonably secure, but more of my income comes from book royalties than salary, and that income is anything but stable. Any day now, someone could come along with a better textbook and put me out of business.

Irving Fisher

Thursday, February 12, 2009

Another Casualty of the Crisis

Junior seminars in economics—the only small undergraduate courses taught by the department’s faculty—may become yet another victim of the University-wide strain borne of the financial crisis. With faculty departing and Harvard’s hiring slowdown hindering their replacement, the already stretched department does not have enough faculty members to teach the seminars, according to some department members.

Labor Market Conditions

Who bears the burden of downturns?

The consumption of high-consumption households is more exposed to fluctuations in aggregate consumption and income than that of low-consumption households in the Consumer Expenditure (CEX) Survey. The exposure to aggregate consumption growth of households in the top 10 percent of the consumption distribution in the CEX is about five times that of households in the bottom 80 percent. Given real aggregate per capita consumption growth about 3 percentage points less than its historical mean during the past year, these figures predict that the ratio of consumption of the top 10 percent to the bottom 80 percent has fallen by about 15 percentage points (relative to trend). Using income data from Piketty and Saez (2003), we show that the income(especially the wage income) of rich households is more exposed to aggregate fluctuations, so their higher income exposure is a likely contributor to their higher consumption exposure.

From their paper, here are growth rates of non-capital gain income by group, 1982-2006:

The End of Welfare Reform As We Know It

One of Bill Clinton's signature achievements was the 1996 welfare reform bill. Now Mickey Kaus tells us that for various technical reasons hidden in the stimulus bill, that reform has been effectively repealed:

my colleague Bob Wright routinely ridiculed me as paranoid for worrying that if Democrats got back in power they would unravel welfare reform. Even I thought I was paranoid. If only for political purposes, I figured, Dems would have to wait a few months or years before sabotaging Bill Clinton's major domestic achievement. It took them two weeks.

I am not enough of an expert on this topic to know if Kaus is right. But if he is, it is an underreported story.

Wednesday, February 11, 2009

News for the Pigou Club

Bad ideas never die

As a textbook author, I am grateful for rent control, because it is a perfect case study of how pernicious price controls can be. This recent news from Albany shows that the example is not about to become dated:

The Democratic-led Assembly passed a broad package of legislation designed to restrain increases on rent-regulated apartments statewide. The legislation would essentially return to regulation tens of thousands of units that were converted to market rate in recent years. In addition, the legislation would reduce to 10 percent, from 20 percent, the amount that a landlord can increase the rent after an apartment becomes vacant.

Deflation Fears Subside

Here (in blue) is the yield on an inflation-adjusted bond and (in red) the yield on a nominal bond of approximately the same time-to-maturity. The negative inflation compensation that showed up a few months ago (when the blue line was well above the red) has shrunk to about zero. These relative yields are moving back toward a more normal, and healthier, alignment.

Ray Fair on the Stimulus

This link has my latest baseline forecast, which assumes no stimulus bill, and then a (crude) stimulus experiment. The stimulus has a big effect in 2010, but by 2012 the economy is roughly back to baseline (except for variables like the federal government debt). In the baseline case the federal debt rises from $5.78 trillion at the end of 2008 to $8.74 trillion at the end of 2012. In the stimulus case the debt at the end of 2012 is $9.34 trillion, about $600 billion more than in the baseline case. This does not take account of possible increases in the federal debt from the bailout activity.

So there is short run gain from the stimulus bill, mostly in 2010, but the potential long run costs do not seem trivial. If the stimulus bill is passed and the bailout continues, it may be that large tax increases will be needed starting in late 2011 or 2012.

The role of the economist in discussions of public policy seems to me to be to prescribe what should be done in light of what can be done, politics aside, and not to predict what is "politically feasible" and then to recommend it.

Tit for Tat

Two of Canada's largest unions are urging the federal government to adopt a Buy Canadian policy similar to the proposal that has been criticized in the United States.At a joint press conference on Tuesday morning, the Canadian Auto Workers and the United Steelworkers said Ottawa should adopt a procurement policy that ensures the majority of public funds are spent on goods and services made in Canada.

Becker and Murphy on Fiscal Stimulus

Monday, February 09, 2009

The Problem with Shovel-Ready

There are no specific parameters or requirements that define shovel readiness. But according to civil engineers, the idea behind this new buzzword could help scuttle the stimulus bill’s highly publicized, though secondary, goal of infrastructure reform. At issue is that 90-day restriction stipulated by Congress, an even narrower window than the bill’s original 180-day limit. “They’re well intentioned, and they know their infrastructure sucks, so they’re trying to do immediate reactive management to what is a very deep, endemic problem,” says Robert Bea, a professor of civil and environmental engineering at the University of California, Berkeley. “If you want to patch some potholes in the road, this is a good program. But if you’re hoping for anything long-term with this approach, throw away all hope. It can’t happen.”

The programs that would meet the bill’s 90-day restriction are, for the most part, an unappealing mix of projects that were either shelved after being fully designed and engineered, and have since become outmoded or irrelevant, or projects with limited scope and ambition. No one’s building a smart electric grid or revamping a water system on 90 days notice....

That might be acceptable to people focused purely on fostering rapid job growth but, ironically, such stimulus spending could fall short on that measure, as well. “In the 1930s, when you were literally building with shovels, that might have made sense. That was largely unskilled labor. Today, it’s blue collar, but it’s not unskilled,” Levinson says. “The guy brushing the asphalt back and forth is unskilled, but the guy operating the steamroller isn’t. And there’s an assumption out there that construction workers are interchangeable between residential and highway projects. But a carpenter isn’t a whole lot of help in building a road.”

Comparing Recessions

Unions win one

President Obama has issued an executive order that permits federal agencies to require union labor for work on federal contracts. This is good news for union workers, bad news for non-union workers, and bad news for taxpayers, who will pay more for what the government buys on their behalf. In my judgment, it is bad news from a macroeconomic perspective. As I learned from Professor Larry Summers, one "cause of long-term unemployment is unionization."

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In correspondence with the economist James Meade in 1942 Keynes says he is “converted” to Meade’s idea of altering the social security payroll tax over the business cycle. Here are Keynes’s words:

I am converted to your proposal…for varying rates of contributions in good and bad times.

(June 16, 1942). Keynes, Collected Writings, vol. 27, p. 208.

…[Y]ou are able to show fluctuations in income of an order of magnitude which is significant in the context… So far as employees are concerned, reductions in contributions are more likely to lead to increased expenditure as compared with saving than a reductionin income tax would, and are free from the objection to a reduction in income tax that the wealthier classes would benefit disproportionately. At the same time, the reduction to employers, operating as a mitigation of the costs of production, will come in particularly helpfully in bad times.

Wage Deflation?

We’re already closer to outright deflation than at any point since the Great Depression. In particular,the private sector is experiencing widespread wage cuts for the first time since the 1930s.

I agree with Paul that persistent deflation would be a problem (for reasons discussed in Chapter 11 of my intermediate macro textbook). But I am not convinced we are close as close to this precipice as Paul suggests. Stories of wage cuts are still anecdotal.

In January, average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 5 cents, or 0.3 percent, seasonally adjusted. This followed gains of 7 cents in December and 6 cents in November. Over the past 12 months, average hourly earnings increased by 3.9 percent.

If we assume the normal 2 percent rate of productivity growth, 3.9 percent wage inflation is consistent with about 1.9 percent price inflation. So, at this point, widespread wage and price deflation seems more of a fear than a reality.

Here is the relevant graph of wage inflation:

Update: Paul Krugman responds that the employment cost index is a better measure of wages than is average hourly earnings. He might well be right about that. But note that his graph still shows positive wage growth, which does not suggest that "the private sector is experiencing widespread wage cuts." He also says he is actually worried "about deflation in a couple of years." So I think Paul and I now agree: As I said in my initial post, at this time, widespread wage deflation is more of a fear than a reality. If that is what Paul meant all along, then I was confused by his use of the present tense in passage I quoted above. I suppose it depends on what the meaning of the word "is" is.

The Japanese Fiscal Experiment

Out with the Old, In with the New

Thursday, February 05, 2009

My Preferred Fiscal Stimulus

Regular readers of this blog have a pretty good sense of my policy preferences. But for those occasional readers who might be stopping by, let me reiterate what I would do right now if I were the fiscal king.

I would institute an immediate and permanent reduction in the payroll tax, financed by a gradual, permanent, and substantial increase in the gasoline tax. I would make the two tax changes equal in present value, so while the package results in a short-run budget deficit, there is no long-term budget impact. Call it the create-jobs, save-the-environment, reduce-traffic-congestion, budget-neutral tax shift.

I recognize that some state governments are now struggling in light of the macroeconomic crisis. For the next two years, I would let each state governor have the authority to divert a portion of the payroll tax cut in his or her state and take the funds instead as state aid. This provision would essentially be giving governors the temporary authority to impose a payroll tax on his or her citizens, collected via the federal tax system. Those governors who think they have valuable infrastructure projects ready to go would take the money. When designing a fiscal stimulus, there is no compelling reason for one size fits all. Let each governor make a choice and answer to his or her state voters. It is called federalism.

Any further federal spending projects should be evaluated on the basis of cost-benefit analysis. That analysis would take time, but it would ensure that the projects are not a waste of taxpayer dollars.

Some traditional Keynesians would object on the grounds that government spending has a larger multiplier than tax cuts. Even though that is the prediction of standard Keynesian models, the evidence is not completely consistent with that conclusion, as I have discussed here in previous posts. In addition, given the lags inherent in large spending projects, and the risks inherent in hasty spending at the federal level, the case for taxes over spending as the fiscal instrument of choice is compelling. To me, at least.

None of this should be viewed as a substitute for fixing the banking system and trying to come up with a better process for homeowners and banks to work out mortgage loans in default. Housing and finance are the real sources of the macro problem. Any fiscal stimulus, such as the one I propose above, is only an attempt to mitigate the symptoms. Those symptoms are severe, so mitigation is fully appropriate. But fiscal policy is not a panacea for what now ails the economy.

The Parable of the Broken Window: Update

Times were so tough for window repairman Timothy Carl Klenke, police say, that he decided to take proactive measures: He armed himself with a slingshot and began cruising around the city, shattering at least five windows and car windshields as he went."

The statements he gave to officers led them to believe he was out to drum up business and was prepared to go out and do some more damage," Redlands police spokesman Carl Baker said Tuesday....

Baker said Klenke, who was arrested Monday, had planned to contact the victims later and offer to repair the windows for a fee.

"I'm sure it has something to do with the economy," Baker said. "Everybody is hurting now."

Interview with Robert Barro

The GOP Mortgage Plan: Con and Pro

Congressional Republicans are proposing that the government offer people 4 percent mortgages, which is below current market rates for mortgages but above the current government bond rate. Harvard economist Ed Glaeser is opposed:

Against modest benefits, the proposed subsidy carries enormous costs. Allowing any credit-worthy borrower to gain access to wildly subsidized lending would lead to a flood of refinancing. Today, Americans owe $10 trillion worth of housing debt and own $19 trillion worth of housing wealth. Logic suggests that a 1.35% interest-rate subsidy on $10 trillion of debt could cost taxpayers upwards of $135 billion.

Subsidizing mortgages is an idea from the New Deal, not the Republican playbook. Fannie Mae and the Federal Housing Administration were set up by liberal Democrats to encourage borrowing. Subsidizing interest rates appealed to big-government interventionists because the expense is kept off federal balance sheets, at least for a while. The true costs of Fannie and Freddie were long shrouded, despite the efforts of some Republican senators. Likewise, the full costs of subsidizing 4% mortgages will appear only over time, as the government is put on the hook for default after default.

there is a plausible diagnosis and a logically consistent argument under which fiscal stimulus could help: We are experiencing a strong portfolio and precautionary demand for government debt, along with a credit crunch. People want to hold less private debt and they want to save, and they want to hold Treasuries, money, or government-guaranteed debt. However, this demand can be satisfied in far greater quantity, much more quickly, much more reversibly, and without the danger of a fiscal collapse and inflation down the road, if the Fed and Treasury were simply to expand their operations of issuing treasury debt and money in exchange for high-quality private debt and especially new securitized debt.

John was not speaking about the Republican mortgage plan (it had not been proposed yet), so I am not exactly sure of his view of it, but his prescription above sounds a lot like the plan, as long as the government makes sure the mortgages are of high quality. Ed might respond to John that if the private debt were high quality, it would not command much of a premium over government bond rates, so the Republican policy would be unnecessary. John might respond to Ed that this would be true in normal times, but credit markets are not functioning as they do in normal times. And the debate goes on....

How might the feds ensure repayment of these mortgages? One possibility is to make them recourse mortgages (that is, the lender would have recourse to the borrower's other assets, if the borrower defaults and the house value falls below the mortgage principal). It could also use the long-arm of the IRS as the collection agency. This latter provision is one advantage the federal government has over private lenders.

Update: I was wrong guessing the implications of John Cochrane's recommendation. He writes me:

I'm with Ed on this one. A vast program to subsidize mortgages is a terrible idea. I don't mind terribly if the Fed buys mortgage backed securities issued at market rates, with a steely eye on not overpaying and buying junk, and so that those securities can be quickly resold when the flight to quality passes. (This is sort of a real-bills doctrine approach.) Even here, though, there are better uses for the Fed's attentions. The conforming (government guaranteed) mortgage market is the one thing that's working reasonably well. That's not an argument for a massive subsidy program on the rates, and especially not direct lending to households. I think the government is way too deep in the mortgage market already.

Thanks, John. Sorry for having put words in your mouth, incorrectly.

As for me, I don't see as large a distinction in principle between John's willingness to buy high-quality mortgage-backed securities and the Congressional proposal of making direct mortgages at rates that exceed the government's cost of capital, as long as the Treasury has mechanisms in place to ensure collection.

Monday, February 02, 2009

Hyperinflation in Zimbabwe: Update

The Problem of Hasty Public Investment

Milwaukee Public Schools would reap $88.6 million over two years for new construction under the economic stimulus package just passed by the U.S. House of Representatives - even though the district has 15 vacant school buildings, a large surplus of property and no plans for new construction....The amounts for MPS are particularly eye-catching, and not only because they are the largest in the state. Enrollment is declining every year, and the last major wave of construction in MPS - the $102 million Neighborhood School Initiative launched in 2000 - resulted in projects that are underused, have not met enrollment projections or have closed.

Rivlin on Stimulus

The first priority is an “anti-recession package” that can be both enacted and spent quickly, will create and preserve jobs in the near-term, and not add significantly to long run deficits. It should include temporary aid to states in the form of an increased Medicaid match and block grants for education and other purposes. Aiding states will prevent them from taking actions to balance their budgets--cutting spending and raising taxes--that will make the recession worse. The package should also include temporary funding for state and local governments to enable them to move ahead quickly with genuinely “shovel ready” infrastructure projects (including repairs) that will employ workers soon and improve public facilities. Another important element of the anti-recession package should be substantial transfers to lower and middle income people, because they need the money and will spend it quickly. This objective would be served by increasing the Supplemental Nutrition Assistance Program (SNAP), unemployment compensation, and the Earned Income Tax Credit. Helping people who lose their jobs to keep their health insurance and aiding distressed homeowners also belong in this “anti-recession” package.

On the tax side, my favorite vehicle would be a payroll tax holiday, because payroll tax is paid by all workers and is far more significant than the income tax for people in the lower half of the income distribution. Moreover, a payroll tax holiday would be relatively easy to reverse when tax relief was no longer appropriate.

This anti-recession package should move forward quickly. Because its components would be temporary, there would be little reason for concern about its impact on the deficit three or four years down the road.

The anti-recession package should be distinguished from longer-run investments needed to enhance the future growth and productivity of the economy.... I understand the reasons for lumping together the anti-recession and investment packages into one big bill that can pass quickly in this emergency. A large combined package will get attention and help restore confidence that the federal government is taking action—even if part the money spends out slowly. But there are two kinds of risks in combining the two objectives. One is that money will be wasted because the investment elements were not carefully crafted. The other is that it will be harder to return to fiscal discipline as the economy recovers if the longer run spending is not offset by reductions or new revenues.

White House Talking Points

CEA Director Romer’s view is that the House analysis is absolutely incorrect. The CEA estimates that the Republican plan would create only 1.7 million jobs, compared to 4.2 million for the Democratic plan.

Question: The House claims that based on the research of CEA Chair Christy Romer, their plan would create 6.2 million jobs. Isn’t that a more effective way of jumpstarting the economy?

Answer: The Republican House analysis is flat wrong in its claim that the House Republican stimulus is more effective. No matter what your analytical assumptions, as long as they are consistent the plan the President supports would result in substantially greater job creation than the House Republican plan.

Independent groups that have analyzed the President’s plan -- from Macroeconomic Advisors to former McCain advisor Mark Zandi -- have confirmed that the President’s plan will create between 3 - 4 million jobs--twice the number of the House plan. The President supports takes a broad, comprehensive approach. It includes substantial tax cuts – many of which mirror the provisions in the House Republican plan. But it also includes new spending programs that many economists across the spectrum believe will help create jobs and give our economy a kickstart right now.

Question: But doesn’t Dr. Romer’s research show that the economic impact of tax cuts is higher than even the Administration is assuming?

Answer: Dr. Romer’s research suggests that all types of fiscal stimulus, both spending and tax cuts, might well have a larger impact than is typically assumed and is assumed in the CEA's analysis. It would be great if that were so. It would mean more job creation and more economic activity -- which is exactly what we need right now. The Administration has based its analyses on more modest assumptions that are in line with those several independent forecasters – Republican and Democrat alike.

We should have an open discussion about these analytical issues.

We cannot afford to play political games with apples-to-oranges comparisons. Such political games distract our attention from the magnitude of the substantive task at hand.

The sentence I put in red is, let's say, a bit of political gaming in itself. (The word "suggests" is a tell.) The Romer research is about the effects of tax cuts. It does not address the effects of increases in government spending. It is consistent with the hypothesis that "all types of fiscal stimulus, both spending and tax cuts, might well have a larger impact than is typically assumed and is assumed in the CEA's analysis." It is also consistent with the hypothesis that tax changes are more potent than spending changes.

How would you sort out which of these two hypotheses is correct?

One way, apparently favored by the White House, is an appeal to theory. If you are sure the basic Keynesian model is correct, then you believe that spending multipliers must be bigger than tax multipliers. So when the Romer research indicates larger tax multipliers than is commonly believed, you must raise your estimate of the spending multiplier as well.

A second way to judge to validity of the two hypotheses is to take a more empirical approach. One possibility is to find an estimate of the spending multiplier. In my NY Times column, I compared Romer's estimate of the tax multiplier to Valerie Ramey's estimate of the government purchases multiplier. (It was actually one of the Obama economists who directed me to the Ramey study.) To some degree, however, that is comparing apples and oranges. An alternative approach is to look at empirical studies that compare tax and spending multipliers. But recent research along those lines is also not consistent with the basic Keynesian story. These empirical studies do not settle the matter: As I pointed out in my Times piece, "whether these results based on historical data apply to our current extraordinary circumstances is open to debate." But these studies should make us wary about applying the simplest textbook model when formulating policy.

What about those independent groups, such as Macro Advisors, that the White House refers to? I have great respect for Macro Advisors. They are very good at what they do, but testing the Keynesian model against alternatives is not what they do. In fact, they do not really have empirical estimates of multipliers that can be used to address this issue. What they have is an empirically calibrated Keynesian model. The structure of the model, which is largely imposed a priori based on conventional Keynesian theory, pretty much ensures the conclusion for the question at hand.

The White House view that government spending is a potent way to get out of a recession is, in essence, a bet on a theory. The theory might be right, but it is certainly one about which many economists have doubts.

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Addendum: Oddly, I could not find these talking points at the CEA website. If the new CEA is going to take public positions like this, I would recommend using the official CEA website rather than Brad's blog as the means of distribution. The CEA website should also post a notice about CEA internships, as we had during my tenure as CEA chair, so students can find out how to apply. Right now, the CEA website is uninformative in the extreme.

Which is worse--the disease or the cure?

Doctors who spent more — on extra tests or high-tech treatments, for instance — didn’t get better results than their more conservative colleagues. In many cases, patients of the aggressive doctors stay sicker longer and die sooner because of the risks that come with invasive care.

The Social Consequences of Economic Downturns

About Me

I am the Robert M. Beren Professor of Economics at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.